Economy and Society is Ballotpedia’s weekly review of the developments in corporate activism; corporate political engagement; and the Environmental, Social, and Corporate Governance (ESG) trends and events that characterize the growing intersection between business and politics.
ESG Developments This Week
In Washington, D.C., and around the world
Will the SEC’s proposed disclosure rule harm materiality standards?
As the Securities and Exchange Commission (SEC) continues to evaluate its options regarding the issuance of a final rule on climate change-related disclosures by publicly traded companies, Bernard S. Sharfman – a senior corporate governance fellow at RealClearFoundation and a research fellow with the Law & Economics Center at George Mason University’s Antonin Scalia Law School – penned a piece for National Review Online’s “Capital Matters” arguing that the new rule will harm the existing materiality standard by creating a new standard – a climate change standard – that is, in his view, based on a fallacy:
“Materiality has been the hallmark of the Securities and Exchange Commission’s disclosure regime since the Supreme Court’s 1976 decision in TSC v. Northway. Materiality limits disclosures “to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.” In the SEC’s recently proposed rule on climate-change disclosures, the SEC tries, but fails, to make the argument that the proposed disclosures will provide investors with “material” information that is critical to their investment decisions. That the SEC even tries to make a materiality argument may surprise many readers, as it is made so indirectly and done so poorly that readers may have missed it.
The materiality argument in the proposed rule revolves around the term “transition risk.” As defined in the proposed rule, this term includes increased operating and investment costs resulting from stricter climate-related regulations, reduced demand for carbon-intensive products, and the potential for stranded assets such as oil and gas reserves.
There are over 100 mentions of transition risk in the proposed rule. It is mentioned so often because the SEC is using it to create the necessary link between its legal authority to require public companies to make disclosures and the disclosures found in the proposed rule. This legal authority requires the SEC’s mandated disclosures to be “for the protection of investors,” a term that requires such disclosures to be directed at informing investors of the firm-specific financial risk that they take when investing in public companies.
As the SEC states in the proposed rule, “Understanding the extent of this potential exposure to transition risks could help investors in assessing their risk exposures with respect to the companies in which they invest.” For example, the SEC tries to justify the need for companies to provide data on Scope 1 (carbon emissions that come directly from sources owned by a company) and Scope 2 emissions (resulting primarily from the generation of electricity purchased and consumed by the company) in the following manner: “Should a transition to a low-carbon economy gain momentum, registrants with higher amounts of Scope 1 and 2 emissions may be more likely to face sharp declines in cash flows, either from greater costs of emissions or the need to scale back on high-emitting activities, among other reasons, as compared to firms with lower amounts of such emissions.” Therefore, transition risk can be thought of as another type of firm-specific financial risk.
The problem with this argument is that transition risk, as defined by the SEC, is not material for most companies and their investors, including companies that focus on the production and refinement of fossil fuels. The materiality of transition risk rests on the false premise that the world is rapidly moving to net-zero carbon emissions and therefore presumably presenting all public companies with a significant amount of such risk.”
Response to proposed Biden administration ESG rule and its potential impact on retirement plans
On July 19, Vivek Ramaswamy, the author, entrepreneur, and executive chairman of Strive Asset Management, and Alex Acosta, the former Trump administration Secretary of Labor wrote a piece for the Wall Street Journal in which they made the case that the Biden Administration’s plans for the new rule on ESG investments in retirement plans are likely, in their view, to be problematic for investors and will create a new tax on retirement accounts. The two wrote the following:
“BlackRock CEO Larry Fink wrote in 2020 that “sustainable investing is the strongest foundation for client portfolios.” Al Gore said in 2021 that “you don’t have to trade values for value. Green can enhance returns.” These claims haven’t aged well: ESG (environmental, social and governance) funds have trailed the market since the beginning of the year and are badly underperforming the sectors they shun, including oil, gas and coal.
That may spur retirement fund managers to reconsider their commitments to ESG funds. But new ESG-favoring regulations may come to the rescue. Last year the U.S. Labor Department proposed a regulation that would tell retirement-fund managers to consider ESG factors such as “climate change” and “collateral benefits other than investment returns” when investing employees’ money.
This would encourage America’s perpetually underfunded pension plans to invest in politically correct but unproven ESG strategies. It would also violate retirees’ basic right to have their money invested solely to advance their financial interests.
Retirement and pension-fund managers are fiduciaries, legally required to make every investment decision with one purpose—maximizing retirees’ financial interests. The Uniform Prudent Investor Act, a model law adopted by 44 states, makes clear that “no form of so-called ‘social investing’ ” is lawful “if the investment activity entails sacrificing the interests of . . . beneficiaries . . . in favor of the interests . . . supposedly benefitted by pursuing the particular social cause.” This principle is built into the Employee Retirement Income Security Act itself, as the Supreme Court held in Fifth Third Bancorp v. Dudenhoeffer (2014). The Biden administration can’t change that by regulation….
The new rule suggests that fund managers weigh factors such as “climate change,” “board composition” and “workforce practices.” While the drafters were smart enough not to mandate consideration of ESG factors explicitly, the draft rule’s one-sided list of examples tilts the scale in favor of ESG-linked investment selection, proxy voting and shareholder engagement.
The rule states not only that ESG factors can be considered, but that prudent investing “may often require” it. The proposed regulation thus transforms ESG from one factor that may be considered when it has a material effect on the investment to a factor that should be considered in all instances.
The new regulation may also expose fiduciaries who don’t consider ESG factors to lawsuits. Already, activist shareholders are pursuing litigation against public companies that don’t take ESG-approved steps.
Washington should remember that the law governing retirement accounts already spells out the ESG goal that fiduciaries must honor: “Providing a secure retirement for American workers is the paramount and eminently worthy social goal of ERISA plans.” The Labor Department should scrap the rule now.”
The ‘S’ in ESG
The British government has come to the conclusion that pension fund managers can and should be doing a great deal to manage the ‘S’ portion of the ESG equation, that is, the social portion–and if they’re not, then they are not performing their duties:
“The U.K. government wants to make sure that pension fund trustees are giving enough attention to social factors that could have financial implications, and is setting up a task force to help.
“The ‘S’ of ESG is one area in which the risk management of pension schemes can be strengthened,” said Pensions Minister Guy Opperman, the longest serving parliamentary undersecretary of state for pensions and financial inclusion, in a statement on the Department for Work and Pensions website.
“In my view, trustees who do not factor in financially material social factors are at risk of not fulfilling their fiduciary duty,” said Mr. Opperman, responding to the results from a Department for Work and Pensions consultation with the pension community on how they approach social risks and opportunities.”
Opperman’s concerns about social matters could, at least in theory, according to some analysts, draw pension managers into conflict over which is most important, social or environmental concerns:
“While some pension funds and service providers reported managing social factors through engagement with companies and others in the investment chain, “there is clearly more to do,” Mr. Opperman said.
One issue raised by trustees was modern slavery within supply chains, which could be exacerbated by global events like the war in Ukraine. The war has also shifted the conversation about investing in defense and nuclear industries, he said.
“This time last year, industries such as defence and nuclear (both civil and defence) were seen as no-go areas for ESG funds but the situation has changed and ESG investing should change with it,” he said. “Recent events have reminded us — if such a reminder were needed — how vital these sectors are to the safety and security of our society.” Pension fund trustees should join the Occupational Pensions Stewardship Council to collaborate on collective engagement and best practices, and when they delegate stewardship, they should “ensure that asset managers do not leave social factors off the agenda,” Mr. Opperman said.”
On Wall Street and in the private sector
Bloomberg: “ESG Fund Closures Pile Up as Do-Good Investing Takes Back Seat”
According to Bloomberg, many ESG funds are not weathering the downturn in the equities markets well:
“A deluge of do-good ETFs once flooded US exchanges and drew in billions. But as investors contend with fears of a recession, the trend is reversing and more of these funds are closing up.
Cathie Wood’s Ark Transparency ETF (ticker CTRU) is the latest ESG exchange-traded fund set to shutter, bringing the total to seven this year. While do-good funds were popular during the post-pandemic bull market when virtually every strategy surged, they now account for 15% of all US ETF closures this year, according to data compiled by Bloomberg. They only made up about 4% of the funds in the industry at the start of the year.
It’s been a brutal turnaround for an investment strategy that grew in popularity as investors sought to finance companies that battle climate change or focus on diversity in their management. An unforgiving year for markets has put do-good investing firmly in the back seat, with investors fleeing ESG funds as portfolio protection becomes a priority.
“This is a really difficult market — I think people tend to go back to the basics,” said Cinthia Murphy, director of research at ETF Think Thank. “We all just want to survive this market and not lose everything we’ve built so far.”
“The ESG ETF space is already over-saturated,” said Nate Geraci, president of The ETF Store, an advisory firm. “We’re going to continue to see an uptick in ESG ETF closures.””
BlackRock – a leader of the ESG investment movement – closed one ESG fund in March and has been leading the market much lower, losing more in the first half of 2022 than any firm in the history of the markets, largely because of its focus on ETFs:
“BlackRock Inc. is used to breaking records. The world’s largest asset manager was the first firm to break through $10 trillion of assets under management. But the bigger they are the harder they fall. And this year BlackRock chalked up another record: the largest amount of money lost by a single firm over a six-month period. In the first half of this year, it lost $1.7 trillion of clients’ money.
BlackRock management was quick to invoke the first-half market carnage when revealing the investment performance last week. “2022 ranks as the worst start in 50 years for both stocks and bonds,” Chairman and Chief Executive Officer Larry Fink said on his earnings call.
While few firms are able to avoid what the market throws at them, some at least try to overcome it. BlackRock is increasingly giving up: At the end of June, only about a quarter of its assets were actively managed to beat a benchmark — rather than track it seamlessly as passive strategies are designed to do. That’s down from a third when BlackRock acquired Barclays Global Investors in 2009 to become the leading player in exchange-traded funds.”